Essential Financial Concepts for Investment Analysis

Core Financial Definitions

• Opportunity Cost: The difference in return between an investment one makes and another that one chose not to make.
• Risk: The possibility that the actual return on an investment will be different from its expected return. A vitally important concept in finance is the idea that an investment that carries a higher risk has the potential for a higher return.
• CAPM: A financial risk model used by analysts in their valuation process (Expected Return = Risk-Free Rate + Specific Stock Beta × Equity Risk Premium).
• DCF: Techniques used by investment bankers for merger and acquisition analysis, Wall Street traders to value all types of debt obligations, and Wall Street analysts to value stock.
• Free Cash Flow to the Firm (FCFF): The amount of cash left over after the payment of investments.
• Weighted Average Cost of Capital (WACC): The weighted average expected cost for a company's various types of obligations—debt, preferred stock, and common stock—issued to finance operations and investments. Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided.
• Flotation Cost: The expense involved in selling a new security issue, including registration and payments to investment bankers. Costs depend on the size and riskiness of the issue and the type of security.

Capital and Operational Budgeting

Capital Budgeting

Capital budgeting is the procedure a financial manager must follow to choose between two or more investment alternatives. When you budget for capital expenditures, you plan to buy assets such as equipment and property expected to last more than one year. These purchases must come from cash on hand to qualify as capital budget expenditures. A capital budget is essential to grow your business by purchasing income-producing assets.

Operational Budgeting

Your operational budget covers day-to-day expenses, including wages, rent, utilities, and purchases of items intended to last less than a year. If you borrow money for capital expenditures, the expense comes out of your operational budget because you must service the loan with monthly payments. The operational budget determines the cash flow required each month to cover bills.

Tax Implications

You can write off operational expenses from your taxes for the year in which they occur (100 percent deduction). Capital expenditures, however, must be depreciated, meaning you deduct a part of the cost of the asset each year over its useful life. Operational write-offs offer the most advantageous tax deductions for the short term.